Section 4: Factor Price Interferences

In most countries around the world when it comes to factor prices, there is a significant degree of government interference. In the labor market, the establishment of a minimum wage means that the wages of certain workers are higher than the free market wage. In some markets, there also may be a cap (a maximum) on wages. For example, in the sports world, some teams are subject to salary caps (these are usually imposed by the league and not by the government). In most Muslim economies, businesses are not allowed to charge interest on money they lend. In most non-Muslim economies, interest rates are determined by the free market. However, countries’ central banks and central monetary agencies heavily influence interest rates by controlling the money supply.

Another example of government factor price setting is rent control. Many large cities around the world require landlords in certain areas to charge rent that is below the free market rent.

Price Interference in the Labor Market: the Minimum Wage

Politicians in industrialized countries often establish a minimum wage in most industries (some industries, for example, restaurant servers, are excluded, because they rely mostly on gratuities). The purpose of a minimum wage is to guarantee any worker a minimum level of income, so that the worker can live at a minimum level of subsistence. Supporters of the minimum wage fear that some businesses exploit workers by paying them a wage that is too low and that will not allow the workers to pay for essential living expenses. There are disadvantages to establishing a minimum wage, as well. The advantages and disadvantages of a government-established minimum wage are listed below.

Advantages and Disadvantages of a Minimum Wage Advantages of a minimum wage that is set above the market wage include

1. Increase in minimum wage worker earnings.
Workers receiving minimum wage earn a greater income as compared to if no minimum wage existed. Keep in mind that total income for the entire economy does not increase (so an increase in the minimum wage does not stimulate the economy), because a $1 increase in a worker’s earnings means a $1 decrease in a company’s income (ceteris paribus). Only if a higher minimum wage makes workers more productive, then an argument can be made that both workers and businesses benefit. Realistically though, productivity gains precede wage increases. In other words, if workers become more productive, then business profits increase and this allows businesses to pay higher wages. The opposite is not true (i.e. higher wages do not lead to greater productivity). So higher wages imposed by government law (minimum wage) do not improve workers’ productivity in the long term (studies show that in the first month or so, productivity increases, but then return to to previous levels). The above is a good example of the fallacy of cause and effect. Greater productivity leads to higher wages, but higher wages do not lead to greater productivity.

2. More incentive to find a job.
A higher minimum wage gives unemployed workers more incentive to search for a job. This increases the quantity supplied of labor.

3. Less chance for exploitation.
In regions where citizens are not mobile (they have little choice but to work for the few firms in the area), businesses may be paying their workers less than the workers deserve and less than what they are worth. Establishing a minimum wage provides these workers with a wage closer to their worth.

Disadvantages of a minimum wage that is set above the market wage include

1.Decrease in employment.
A higher minimum wage (if the minimum wage is set above the market wage) leads to an increase in a business’s cost of production. This results in a decrease in employment.

An increase in the minimum wage causes business costs to increase. In an effort to save costs some businesses (especially small businesses) choose to lay off full-time workers (who receive benefits) and replace them with part-time workers (who don’t receive benefits). This may leave the unemployment rate unchanged (it may even lower the unemployment rate if for example, 10 full-time workers are laid off and 12 part-time workers are hired), but it will lower the total number of hours worked and it will lower overall income.

2. Increase in prices.Higher production costs for businesses may result in higher prices. This may also lead to a decrease in exports, as foreign countries have to pay higher prices for our products.

3. Lower profits.Higher production costs for businesses result in lower profits for businesses. Therefore, businesses have less ability to provide funds for business expansions, research and development, benefits, and training.

4. Decreased worker incentive to be productive.
Automatic increases in the minimum wage result in less incentive for the worker to be productive. While at first (within the first weeks of a minimum wage increase) workers may feel motivated to work harder, in the long run, if workers know that they will get a raise automatically, as established by law, they will lose the incentive to earn the increase in their wage.

Below is a graph of a market for labor. Businesses demand the labor. Citizens supply the labor. In a free market, the equilibrium wage is at the intersection of the demand and supply curves. If the government sets the minimum wage above the equilibrium wage, the quantity demanded of labor decreases, and the quantity supplied of labor increases. This results in a surplus of labor. Ceteris paribus (all other things remaining constant), this increases unemployment.

Labor Unions and Wages

Labor unions are supported by most industrialized governments and many pro-union labor laws. Unions protect workers’ rights, and can serve a useful purpose in negotiating with a business that treats workers less than fair. However, unions can also contribute to above-market wages and higher prices. Their collective bargaining powers and strike threats push wage rates well above free market levels, raise prices, and often place companies at an internationally competitive disadvantage. Furthermore, unions’ restrictions about what workers are allowed to do, how much they are allowed to work, and other unnecessary staffing requirements, lead to inefficiencies in production and raise businesses’ cost of production. These inefficiencies may lead to long-run unemployment, as firms go bankrupt or move abroad.

Unions may be credited for improved working conditions and higher wages. However, improved working conditions and higher wages are only possible if firms can afford them. Only increased productivity and increased profits allow firms the means to improve working conditions and increase wages. When unions have suggested measures that have led to productivity improvements, it has been beneficial. But most of the time, unions suggest changes that may increase short-term employment, but hinder productivity and technological advances. Greater profits made possible by business investments, technology advances, and entrepreneurial initiatives have been the real cause of improvements in working conditions and better wages and benefits. This is because the greater profits have, over time, enabled businesses to afford these luxuries.

Raising Real Wages

Some economists believe that an artificial increase of workers’ wages (such as an increase in the minimum wage beyond the equilibrium price, or union wage demands beyond what productivity increases warrant) is not the answer to the economic problems of low-income earners. They state that these artificial increases merely increase nominal wages, but not real wages.

How then can we achieve higher real wages?

Answer: By increasing productivity.

How can we increase productivity?

Answer: By providing an economic system that rewards work and innovation and by providing an economic system in which businesses and entrepreneurs have maximum incentive to innovate and increase theirs and, therefore, everyone’s wealth. And by providing a proper reward system in which taxes are low, regulations reasonable, and subsidies and handouts not excessive.

One of the keys to improving a country’s standard of living is to increase real wages. Real wages increase with increases in a firm’s productivity. Productivity is a function of technological advances. Technological advances are encouraged by a reward system that provides incentives for entrepreneurs and other workers to earn reasonable profits and incomes. This means that taxes and other costs of working and doing business (for example, regulations) must be kept reasonably low.